Understanding Standard Deviation

It’s not unusual for investors to use standard deviation – a statistical measure of volatility – as a guide to assess the long-term performance of mutual funds.

While there are some merits to using standard deviation, it is useful to note that it is not an indicator of future performance because it is calculated using the past performance of a mutual fund.

Essentially, what standard deviation indicates is the degree of variation from the average (or mean) return of a mutual fund. Therefore, a higher standard deviation indicates that a fund is more volatile than one with a lower standard deviation. But this degree of variation, is not an indication as to whether the returns of the fund are above or below its mean return over a specified time period.

In practice, standard deviation and volatility are normally used interchangeably. Standard deviation rises when security prices are volatile and falls when they stabilize.

Calculating the standard deviation of a fund is somewhat complex and is based on the degree of variation from the mean, measured in percentage terms.

For illustration purposes, if a mutual fund has an average annual return of 8% and a standard deviation of 3%, then investors can expect the return of the fund to be between 5% and 11% (or 8% ± 3%), 68% of the time, that is, one standard deviation from the mean, and between 2% and 14% (or 8% ± 6%), 95% of the time, that is, two standard deviations from the mean.

When relying on standard deviation as a guide to determining long-term performance, investors should keep in mind that this measure is only useful when analyzing the past performance of a single mutual fund. It is also important to note that past performance of a mutual fund is not an indicator of future performance.